Risk and Return
Risk is the uncertainty that you may not earn your expected return on your investments. For example, you may expect to earn 20% on your stock mutual fund every year, but your actual rate of return may be much lower.
For example, the S&P 500 index averaged yearly gains of about 28% for the five years that ended in 1999. In 2000, however, the index declined more than 9%, in 2001 declined another 12%. Bonds, meanwhile, performed better than stocks for the first time since 1990. The S&P 500 index was back in the black in 2003 through 2007, averaging just over a 9% annual return.
The peril of investing in the stock market between 2000 and 2001 underscores the risk-return trade-off. The risk-return trade-off requires that you accept more risk in exchange for the chance to earn a higher rate of return. If unwilling, you should expect to earn a lower return. Conservative investors, for example, are less willing to lose 10% of their investments in exchange for the chance to earn a higher rate of return. Aggressive investors, on the other hand, are willing to accept this risk in exchange for the chance to earn higher returns.
Some investors argue that the late-1990s was a unique period where a unique set of factors drove stock market indexes to record highs. The Internet allowed millions of individuals to buy and sell stocks and mutual funds for the first time. Venture capital firms plowed billions of dollars into companies that went on to sell shares in initial public offerings. In addition, American businesses spent billions of dollars on information technology. This combination of factors may have led investors to lose sight of the risk-return tradeoff.
The following table shows how the risk-return relationship has held over the long term. Annual rates of return are shown for stocks, bonds, and cash for the 50 years ended in 1996:
|Annual rates of return,|
1946 to 2003
|Unadjusted for inflation||11.6%||6.0%||4.7%|
|Adjusted for inflation||7.5%||1.9%||0.6%|
|Best annualized return|
(5-year holding period)
|Worst annualized return|
(5-year holding period)
Source: American Association of Individual Investors
The table shows that, of the three major asset classes, stocks offered the greatest rates of return over the long term, but stocks were also the most volatile. Divided into holding periods of five years, stocks lost 2.4% in their worst period. Bonds and cash never lost money in any of the periods.
To some degree, you can reduce risk by hedging or diversifying your investments. However, the risk-return trade-off steers investors with little or no risk tolerance toward making smaller allocations to stocks than investors with a high degree of risk tolerance.
Major types of risk include:
Investment risk.Investment risk is the chance that your investment value will fall. Standard deviation is commonly used to measure investment risk. It shows a stock or bond's volatility, or the tendency of its price to move up and down from its average. As standard deviation increases, so does investment risk.
A common measure of portfolio risk is the beta coefficient. Beta is a value that ranges from +1.0 to -1.0. A portfolio with a beta of +1.0 earns a rate of return that is identical to that of the benchmark index used to compare the portfolio's return. A portfolio with a beta of -1.0 earns a rate of return that is exactly opposite to that of the benchmark index. By investing in securities that have a low or negative beta, you can diversify your investment risk.
Market risk. Market risk is the chance that the entire market where your investment trades will fall in value. Market risk cannot be diversified.
Interest rate risk.Interest rate risk is the chance that interest rates will change while you hold an investment. Higher rates result in lower returns on stocks and bonds, but higher returns on interest-paying investments.
Inflation risk. Bonds are especially vulnerable to inflation risk. This is because a bond's coupon payment is usually a fixed amount. When inflation rises, the present value of the coupon falls. Stocks have less risk since dividends can be adjusted for inflation.
Industry risk. Industry risk is the chance that a set of factors particular to an industry group drags down the industry's overall investment performance. For example, cold weather might adversely affect the retail industry or a cutback in capital spending might adversely affect the information technology industry.
Credit risk.Credit risk is the chance that the company selling bonds is unable to make debt payments. As a result, the company may default on its debt or have to file for bankruptcy.
Liquidity risk.Liquidity risk is the chance that your stock or bond investment cannot be sold easily because of a lack of buyers. Such a security is called a thinly-traded security. As a result of a lack of liquidity, you may have to sell the investment at a price below its fair value.
Currency risk. When you buy a company's stocks or bonds, you are buying a piece of that company's business operations. If the company sells products in other countries, you also face the same currency risk the firm faces. The company may or may not hedge its currency risk.
Currency risk exists in some mutual funds that invest in stocks and bonds of companies outside the U.S. For example, if you buy shares of a mutual fund that invests in Japanese companies, and the Japanese yen falls in value, the dollar value of your fund shares also drops. If the fund has not hedged its currency exposure, it will face a loss in the value of its yen-denominated investments when it repatriates income to the U.S.
Prepayment risk.Prepayment risk affects investors of bonds that are backed by thousands of mortgage loans or millions of dollars of credit-card receivables. Prepayment risk is the chance that borrowers repay debts ahead of schedule. As a result, investors are repaid sooner than expected and have to invest these prepayments when interest rates may not be as high. Borrowers refinance when interest rates decline, increasing prepayment risk.